Q1) why do you think critics are worried that the rapid growth in the use of derivatives might

destabilize global financial market?

A derivative transaction is a contract whose value depend on (derives from) the value of underlying asset, reference rate index, Derivatives include forward, future, swap and option transactions that are based on internet rates, currencies, equities and commodities. Derivatives have been in used for 100 years, their popularity has grown rapidly in recent years. Too many critics, that rapid rise if derivatives trading in global financial market was dangerous and potential destabilizing influence in the world economy these critics used the collapse of barring to intensify their calls for tighter regulation for global derivatives trading. But other argued when employed comely derivatives can be used to reduce risk, not increase it. They say that the ease with colic worlds financial market absorbed the shock of the barring collapse is proof that the global financial system is around and should not be during 1970s and 1980s, corporation and traders increasingly turned to derivative contracts to insure against possibly adverse future changes in a wide range of other assets such as:
For an example of a derivative contract for a commodity, consider a company that knows it will need to purchase 1 million barrels of oil in six months. Imagine that the current price of oil is $15 per barrel, but the company fears that the price may rise substantially over the next six months because of turmoil in Saudi Arabia, the worlds largest oil exporting nation. The company can either wait or bear the risk that the price of oil might rise in six months, or it can enter into a futures contract today. Under this contract, it might agree to Purchase the price of oil in six months at $16 per barrel. The $1 difference between the price of oil today and the Price specified in the contract represents an insurance, or hedge, against a possible rise in the future price of oil. By entering into the contract, the company has reduced its exposure to future rises in oil prices; it has reduced its risk.

A stock option is a contract that gives the owner the right to purchase or sell a specific number of shares at a fixed price within a definite time. For example, imagine that you hold 1,000 shares of Compaq Computer, which is trading at $50 per share (the market value of your holding is $50,000). You fear that due to a temporary slowdown in the growth rate of personal computer sales, the price of Compaq might fall in the near future, but you dont want to sell the stock because you like Compaqs long-term prospects. You know that it is by no means a sure thing that sales are slowing, and Compaq could continue to do well even if sales do slow. You might decide to take out insurance against the possibility that the stock will fall by purchasing a put option. The put option contract might give you the right but not the obligation to sell 1,000 shares of Compaq in three months at $50 per share to the writer of the option. The put option might cost you $1 per share, or $1,000.

Q2) Do you think derivatives are risky and speculative financial instruments or instruments that can be used to reduce an investors risk? As we now that trading are moving from fixed rate to floating rate derivatives play here a vital role, without any doubt somehow it is true that derivatives are risky and reduce the instruments that reduce the investors risk but here is some positive points of derivatives we also such as limiting the risk or losses investors. Derivatives include forward, future, swap, and option transactions that are based on interest rates, currencies, equities, and commodities. Derivatives have been in use for at least 100 years, although their popularity in recent years has grown rapidly. In 1986, derivative contracts with a notional value of about $1 trillion were traded annually. By 1990, this figure had risen to $5 trillion, and it approached $20 trillion by 1994. This rapid growth in the volume of derivative trading has raised fears that derivatives might destabilize the world

financial system. Under a floating exchange rate regime, exporters and importers hedged (insured against) adverse currency changes by purchasing foreign currency through forward exchanges or by engaging in currency swaps. During the 1970s and 1980s, corporations and traders increasingly turned to derivatives contracts to insure against possibly adverse future changes in a wide range of other assets such as commodities, bonds, or stocks. Followings are the examples: 1. For an example of a derivative contract for a commodity, consider a company that knows it will need to purchase 1 million barrels of oil in six months. Imagine that the current price of oil is $15 per barrel, but the company fears that the price may rise substantially over the next six months because of turmoil in Saudi Arabia, the worlds largest oil exporting nation. The company can either wait or bear the risk that the price of oil might raise in six months, or it can enter into a futures contract today. Under this contract, it might agree to purchase the price of oil in six months at $16 per barrel. The $1 difference between the price of oil today and the price specified in the contract represents an insurance, or hedge, against a possible rise in the future price of oil. By entering into the contract, the company has reduced its exposure to future rises in oil prices; it has reduced its risk. 2. Another common form of derivative is a stock option. A stock option is a contract that gives the owner the right to purchase or sell a specific number of shares at a fixed price within a definite time. For example,

imagine that you hold 1,000 shares of Compaq Computer, which is trading at $50 per share (the market value of your holding is $50,000). You fear that due to a temporary slowdown in the growth rate of personal computer sales, the price of Compaq might fall in the near future, but you dont want to sell the stock because you like Compaqs longterm prospects. You know that it is by no means a sure thing that sales are slowing, and Compaq could continue to do well even if sales do slow. You might decide to take out insurance against the possibility that the stock will fall by purchasing a put option. The put option contract might give you the right but not the obligation to sell 1,000 shares of Compaq in three months at $50 per share to the writer of the option. The put option might cost you $1 per share, or $1,000. If the price of Compaq shares does not fall, the put option contract might expire worthless in three months. However, if Compaq shares fall to $40, the put option contract will rise to about $10 per share. You can either sell the shares for $50 each to the writer of the put option, or you could sell the option contract for $10,000 (1,000 shares at $10 per share) and pocket the $9,000 profit while holding onto the shares. Whatever action you choose, although the value of your Compaq stock has fallen from $50,000 to $40,000 over the three months, your actual loss is limited to just $1,000, the price of the put option contract. By purchasing a put option contract, you have limited your exposure to a fall in the price of Compaq shares.

3.

In addition to put options, one can also purchase call options. Call options are simply the reverse of put options. They are an option that gives you the right to purchase a certain number of shares from the option writer at a fixed price within a specified time. For example, if you think that Compaqs price might rise from $50 to $80 per share, but you are unwilling to purchase another 1,000 shares for $50,000 at this time, you could enter into a call option contract that gives you the right to purchase 1,000 shares from the call option writer in three months at $50 per share. Again, the option contract might cost you $1 per share. If the price of shares goes up to $80, you will make a large profit. If the price falls, your loss is limited to the $1,000 cost of the call option contract.

in the fact that Nick Leeson did not have a manager or chain of command. Moreover Barings started hiring young moderately experienced college graduates and positioned them high in the organization well above seasoned senior employees. This created an organization structure that was experienced at the bottom but nave at the critical decision making top level. From a control standpoint, although Barings knew that trading, and future and options must be segregated to prevent fraud, it did not act on it until it was too late. Emphasis on risk management always took a backseat until the new asset and liability committee (ALCO) was formed n August 1994; two years after the merger. were no systems for checks and balances as is clear from the fact that Leeson had unfettered access to Barings funds. To conclude I must say that bearing collapse dose not expose a downfall in the fundamental financial system.

Q4) What is your view on the basic causes of the collapse of Barings Bank?
Barings Bank was one of the oldest merchant banks in London, dating back to 1762, even managing to penetrate foreign markets. Barings Bank was commonly known as the Queens bank, as Queen Elizabeth II used the banks services. The collapse of the two and thirty three year old bank in February of 1995 is perhaps the quintessential tale of financial risk management gone wrong. The failure was completely unexpected. Over a course of a few days, the bank went from apparent strength to bankruptcy. Barings was Britain's oldest merchant bank. It had financed the Napoleonic wars, the Louisiana Purchase, and the Erie Canal. What really grabbed the world's attention was the fact that the failure was caused by the actions of a single trader who goes by the name Nick Leeson, based at a small office in Singapore despite surviving the Great Depression and both World Wars. As just mentioned the person responsible for the collapse of Barings Bank was Nick Leeson, who was born in Watford, a suburb of London, England in February of 1967. After finishing

Q3) Does the collapse of Barings expose a fundamental flaw in the global financial system? If so, how might this flaw be fixed?
The roots of Barings collapse lie in the merger between Barings private banking division and its securities division. As noted in the case; the private banking division was a cautious no risk family run business and the securities division was aggressive and opportunity seeking. Clearly there was a clash of cultures. The reasons behind the clash must have been to do with not having common ground and definitions of basic assumptions, values, beliefs, and norms. Barings did not do a good job of identifying a middle ground for a common culture, post-merger. Organizationally, Barings merged the two divisions in 1992 and attempted to have a congruent matrix organization. The matrix organization was ill formed and this is evidenced

Sixth Form, Leeson landed a job as a clerk with an exclusive private bank, Coutts. He then moved to Morgan Stanley in 1987 for two years eventually ending up with Barings in 1989. By 1992, three years later, Leeson was appointed general manager of a new operation in futures markets on the Singapore International Monetary Exchange (SIMEX). Barings had held a seat on the Singapore International Monetary Exchange for some time, but did not activate it until Leeson was sent over. Leeson's previous accomplishments in Jakarta while working for Barings Bank attracted the attention of the Barings Banks management. When he applied for a position within Barings Securities (Singapore), they not only accepted him, but they made him general manager with authority to hire traders and back office staff. Leeson arrived at Barings Securities (Singapore) in 1992 and started hiring local staff. As general manager, Leeson's job was not trading, but he soon took the necessary exam so that he could trade on the Singapore International Monetary Exchange along with his small team of traders.

He was now general manager, head trader and, due to his experience in operations, was also head of the back office. Such an arrangement should have rung alarm bells, but no one within Barings' senior management seemed to notice the blatant conflicts of interest. Perhaps it was the inherent lack of risk in such trading that prompted people to not be concerned about Leeson wearing multiple hats. Leeson would be trading on the futures market and at the same time, be in charge of booking and reporting the various trades. In a normal day, he would work in the Singapore Money Exchange until trading closed at 2pm, and then would go to the office (or 'back room') where all the records of the day's trades were recorded. This meant in particular that Leeson would be the only one to check and to know if the records matched the actual sales. Usually, a different person is doing the back office accounting, to detect any dodgy deals. However, this was not the case at Barings, giving Leeson the dreadful power to cover his tracks in case of any substantial loss or illicit trading.

The back-office records, confirms and settles trades transacted by the front office, reconciles them with details sent by the bank's counterparties and assesses the accuracy of prices used for its internal valuations. It also accepts/releases securities and payments for trades. Some back offices also provide the regulatory reports and management accounting. In a nutshell, the back office provides the necessary checks to prevent unauthorised trading and minimise the potential for fraud and embezzlement. Since Leeson was in charge of the back office, he had the final say on payments, ingoing and outgoing confirmations and contracts, reconciliation statements, accounting entries and position reports. Thus Leeson was considered to be in a perfectly placed position to relay false information back to London and thus hiding all his tracks and losses. Leeson and his traders had authority to perform two types of trading: Transacting futures and options orders for clients or for other firms within the Barings organization, and Arbitraging price differences between Nikkei futures traded on the Singapore International Monetary Exchange and Japan's Osaka exchange. It all started 1992 when Leeson started making unauthorized speculative trades that at first made large profits for Barings; 10 million which accounted for 10% of Barings' annual income that year. For that he earned a bonus of 130,000 on his salary of 50,000 for that year. However, his luck soon went sour, and he used one of Barings' error accounts (accounts used to correct mistakes made in trading) to hide his losses. The infamous account was numbered 88888 a number considered very lucky in Chinese numerology. Leeson claims that this account was first used to hide an error made by one of his colleagues - rather than buy 20 contracts as the customer had ordered, she had sold them, costing Barings 20,000. However, Leeson used this account to cover further bad trades. He insists that he never used the account for his own gain, but in 1996 the New York Times quoted "British press reports" as claiming that investigators had located approximately $35 million in various bank accounts tied to him. Management at Barings Bank also allowed

Leeson to remain Chief Trader while also being responsible for settling his trades, jobs usually done by two different people. This made it much simpler for him to hide his losses from his superiors. The beginning of the end for Barings Bank started on the 16 January 1995, when Leeson placed a short straddle in the Singapore and Tokyo stock exchanges, essentially betting that the Japanese stock market would not move significantly overnight. However, the Kobe earthquake hit early in the morning on 17 January, sending Asian markets, and Leeson's trading positions, into a tailspin. Leeson attempted to recoup his losses by making a series of increasingly risky new trades (using a Long-Long Future Arbitrage), this time betting that the Nikkei Stock Average would make a rapid recovery. However, the recovery failed to materialize. Before the earthquake, the Nikkei Stock Exchange traded in a range of 19,000 to 19,500 contracts. Leeson had long futures positions of approximately 3,000 contracts on the Osaka Stock Exchange. A few days after the earthquake, Leeson started an aggressive buying programme which culminated in a high of 19,094 contracts reached about a month later. The huge Futures position of Nick Leeson was simply part of his trading mandate and no one would suspect any suspicious trading loss behind. Leeson's position on the Osaka Stock Exchange was publicly known as the exchange report such positions each week. Barings London thought that this long position was matched by a short position of the same notional value. This implies being short twice as many contracts as the Singapore International Monetary Exchange contracts are, with a notional twice as small as the one of Osaka's contracts. But, contrary to what the senior management was thinking, Nick Leeson was in fact long the same amount in the Singapore International Monetary Exchange. Nick Leeson managed to hide his real position in a secret account known as an Error account and with the infamous number of 88888. It was possible to dissimulate his position and to use the 88888 account because uncommonly for a trader, he was responsible both for front and back office as mentioned earlier. Leeson bought a substantial number of contracts, 11,000 on the

20th of January 1995, just three days after the earthquake in Kobe. Probably, he thought that the market had overreacted and that the fall of the Nikkei 225 from 20,000 to 18,950 was only temporary. But the Nikkei 225 dropped even further and by Monday 23rd 1995, the Nikkei 225 was around 17,950. At the end of February 1995, Nick Leeson had leveraged his position to $7bn, holding about 61,000 contracts (55,000 March contract and 6,000 June contracts). His position on the Singapore International Monetary Exchange was 8 times bigger than the next largest position. Although he could have hidden the position for quite a while because the margin called were only a small proportion of the notional value, his position was too big not to be discovered. The margin calls were enormous and Barings Tokyo London had to transfer urgently a massive $835m to Barings Singapore in January and February to cover the margin calls on Singapore International Monetary Exchange. These calls made finally Barings bankrupt as its reported capital was only of $635m. Leeson has claimed that he originally used the 88888 account to hide some embarrassing losses resulting from mistakes made by one of his female traders who lost 20,000. However, Leeson started actively trading in the 88888 account almost as soon as he arrived in Singapore. The sheer volume of his trading suggests a simple desire to speculate. He lost money from the beginning. Increasing his bets only made him lose more money; the margins were just too small. For example, one could buy a futures contract on the Nikkei Exchange worth $100 million on one day but at the same time sell the same product in Singapore for say $100,001,000. Though a person would have bought and sold nearly 200 million, their profit is only $1,000, which is 1,000 dollars for a 100 million dollar investment. However, instead of hedging his positions, Leeson gambled on the future direction of the Japanese markets. If one uses the above example, one could buy $100 million worth of Nikkei futures contracts then hope that the contract price goes up in future. In this instance, even a percentage change of the price would create 1 million dollar worth of profit or loss. By the end of 1992, the 88888 account was under water by about 2 million. A

year later, this had mushroomed to 23 million. By the end of 1994, Leeson's 88888 account had lost a total of 208 million. Barings management remained blithely unaware. By performing futures transactions at off-market prices, Leeson was able to achieve profits in the arbitrage accounts while placing offsetting losses in the 88888 account. During 1994, Leeson booked 28.5 million in false profits. This was a staggering profit to earn from futures arbitrage, but it ensured that Barings employees earned bonuses that year. Needless to say, there was little incentive for employees to question the unusually high arbitrage profits. If anything, Leeson was viewed as a star trader who was not to be interfered with. The most striking point is the fact that Leeson sold 70,892 Nikkei 225 options worth about $7 billion without the knowledge of Barings London. Leeson earned premium income from selling well over 37,000 straddles over a fourteen month period. Such trades are very profitable provided the Nikkei 225 is trading at the options' strike on expiry date since both the puts and calls would expire worthless. If the Nikkei is trading near the options' strike on expiry, it could still be profitable because the earned premium more than offsets the small loss experienced on either the call (if the Tokyo market had risen) or the put (if the Nikkei had fallen). The strike prices of most of Leeson's straddle positions ranged from 18,500 to 20,000. Leeson thus needed the Nikkei 225 to continue to trade in its pre-Kobe earthquake range of 19,000 20,000 if Leeson was to make money on his option trades. The Kobe earthquake shattered Leeson's options strategy. On the day of the quake, January 17, the Nikkei 225 was at 19,350. It ended that week slightly lower at 18,950 so Leeson's straddle positions started to look shaky. The call options Leeson sold looked worthless but the put options became very valuable to their buyers if the Nikkei continued to decline. Leeson's losses on these puts were unlimited and totally dependent on the level of the Nikkei at expiry, while the profits on the calls were limited to the premium earned. When the Nikkei dropped 1000 points to 17,950 on January 23, 1995, Leeson found himself showing losses on his two-day old long futures

position and facing unlimited damage from selling put options. Leeson, tried singlehandedly to reverse the negative post-Kobe sentiment that swamped the Japanese stock market. On 27 January, account 88888 showed a long position of 27,158 March 1995 contracts. Over the next three weeks, Leeson doubled this long position to reach a high on 22nd February of 55,206 March 1995 contracts and 5640 June 1995 contracts. Essentially how was Leeson able to deceive everyone around him? How was it possible for him to post profits on his 'switching' activity when he was actually losing? The means used to effect this deception was the cross trade. A cross trade is a transaction executed on the floor of an Exchange by just one Member who is both buyer and seller. If a Member has matching buy and sell orders from two different customer accounts for the same contract and at the same price, he is allowed to cross the transaction (execute the deal) by matching both his client accounts. A cross- trade must be executed at market-price. Leeson entered into a significant volume of cross transactions between account 88888 and account 92000 (Barings Securities Japan - Nikkei and JGB Arbitrage), account 98007 (Barings London - JGB Arbitrage) and account 98008 (Barings London - Euroyen Arbitrage). After executing these cross-trades, Leeson instructed the settlements staff to break down the total number of contracts into several different trades, and to change the trade prices thereon to cause profits to be credited to 'switching' accounts referred to above and losses to be charged to account 88888. Thus while the cross trades on the Exchange appeared on the face of it to be genuine and within the rules of the Exchange, the books and records of Barings Securities Singapore, maintained in the Contac system, a settlement system used extensively by Singapore International Monetary Exchange members, reflected pairs of transactions adding up to the same number of lots at prices bearing no relation to those executed on the floor. The bottom line of all these cross-trades was that Barings was counterparty to many of its own trades. Leeson bought from one hand and sold to the other, and in so doing did not lay off any of the firm's market risk. Barings was thus not

arbitraging between Singapore International Monetary Exchange and the Japanese exchanges but taking open (and very substantial) positions, which were buried in account 88888. It was the profit and loss statement of this account which correctly represented the revenue earned (or not earned) by Leeson. Details of this account were never transmitted to the treasury or risk control offices in London, an omission which ultimately had catastrophic consequences for Barings shareholders and bondholders. The management of Barings broke a cardinal rule of any trading operation - they effectively let Leeson settle his own trades by putting him in charge of both the dealing desk and the back office. This is practically the same as allowing a person who works a cash-till to personally take in the day's takings without an independent third party checking whether the amount banked in at the end of the day reconciles with the till receipts. Despite his having to fund millions of GBP in losses, there were various factors that allowed Leeson to avoid discovery. At the time, there was a merger going on between two parts of the Barings organization. Barings had acquired stock brokerage firm Henderson Crosthwaite in 1984, which became Barings Securities Limited. In November 1993, Barings Securities Limited was merged into Baring Brothers & Co. in anticipation of a subsequent initiative to form a Barings Investment Bank. The merger was not easy because the two firms had markedly different cultures. It was a distraction right in the middle of Leeson's tenure at Barings Securities Limited. Barings was just starting to form a risk management function. Risk controllers were appointed in London, Tokyo and Hong Kong during 1994, but not in Singapore. In Barings Securities (Singapore), Leeson effectively controlled the front and back offices. There was no middle office. Also, there was no single person within Brings responsible for supervising Leeson. As part of the 1993 reorganization, Barings had adopted a "matrix" approach to management of its offices. There was one reporting structure based upon products that cut across all offices. Another was based upon operations, ensuring local management of such items as systems, controls, settlement and accounting. Employees

complained that lines of reporting were not always clear. Another issue was that Leeson was an accomplished liar. He falsified records, fabricated letters and made up elaborate stories to deflect questions from management, auditors and even representatives of Singapore International Monetary Exchange. Leeson also actively played on people's insecurities, profiting on such feelings. On 23 February 1995, Leeson left Singapore to fly to Kuala Lumpur. Barings Bank auditors finally discovered the fraud around the same time that Barings' chairman, Peter Baring, received a confession note from Leeson. Leeson's activities had generated losses totalling 827 million (US$1.3 billion), twice the bank's available trading capital. The collapse cost another 100 million. The Bank of England attempted a weekend bailout, but it was unsuccessful. Employees around the world did not receive their bonuses. Barings was declared insolvent on 26 February 1995 and appointed administrators began managing the finances of Barings Group and its subsidiaries. The same day, the Board of Banking Supervision of the Bank of England launched an investigation led by Britain's Chancellor of the Exchequer and their report was released on 18 July 1995. Barings Banks shareholders lost an estimated 1 billion. After learning of Barings' collapse (and realizing he was certain to be jailed for his actions), Leeson booked a flight to London where he intended to surrender to British police in hopes of serving prison time in the United Kingdom as opposed to Singapore. However, he was apprehended by German authorities when he landed in Frankfurt, six days after fleeing Singapore. Leeson spent the next several months in German custody unsuccessfully fighting extradition back to Singapore. British authorities declined to pursue extradition of Leeson back to England. Convicted of fraud, Leeson was eventually sentenced to six and a half years in prison in Singapore, but was released early in 1999 after being diagnosed with colon cancer and for good behaviour. Despite grim forecasts at the time, he did not succumb to the disease, and is alive till today. Leeson is now the CEO of the Irish football team Galway United. As a result of Barings Banks collapse and solvency, ING, a Dutch bank, purchased Barings

Bank in 1995 for a symbolic sum of 1 and assumed all of Barings' liabilities, forming the subsidiary ING Barings. In 2001, ING sold the U.S.-based operations to ABN-Amro for $275 million, and folded the rest of ING Barings into its European banking division. This left only the asset management division, Baring Asset Management. In March 2005, BAM was then split and sold by ING to MassMutual (acquiring BAMs investment management activities and the rights to use the Baring Asset Management name) and Northern Trust (acquiring BAMs Financial Services Group). Barings Bank therefore no longer has a separate corporate existence, although the Barings name still lives on as the MassMutual subsidiary, Baring Asset Management. The derivative trading is not as easy as perceived. Here is a clear case which shows the instincts of how risky the business is. The chain of events which led to the collapse of Barings, Britain's oldest merchant bank, is a demonstration of how not to manage a derivatives operation. The control and risk management lessons to be learnt from this collapse apply as much to cash positions as they do to derivative ones. The leverage and liquidity offered by futures contracts brings down an institution with lightning speed which is in contrast to bad loans or cash investments whose ill-effects takes years to ruin an institution.